A Theory of Banks, Bonds, and the Distribution of Firm Size

We draw on stylized facts from the finance literature to build a model where altering the relative costs of bank and bond financing changes the entire distribution of firm size, with implications for the aggregate capital stock, output, and welfare. Reducing transaction costs in the bond market increases the output and profits of midsize firms at the expense of both the largest and smallest firms. In contrast, reducing the frictions involved in bank lending promotes the expansion of the smallest firms while all other firms shrink, even as it increases the profitability of both small and midsize firms. Although both policies increase aggregate output and welfare, they have opposite effects on the extensive margin of production—promoting bond issuance causes exit while cheaper bank credit induces entry. When reducing transaction costs in one market, the resulting increase in output and welfare are largest when transaction costs in the other market are very high.